Qualifying income is a very significant part of a residential mortgage application.  A lender wants to ensure that an applicant (or applicants) can afford the mortgage and has a way of making the scheduled payments. So one of the golden rules is, have an income if applying for a mortgage.  Beginner real estate investors should take note, it
is not wise to simply quit your job and be a fulltime investor if you want to apply for mortgages and build your real estate portfolio.

Mortgage applicants generally fall into three income qualifying categories.

The most common category is an employee, who receives paystubs, regular pay deposits in bank account, and a T4 tax slip at the end of the calendar year.  This income is reported on personal tax return and is easily verifiable.  Essentially what you see is what you get.  Retirement pension income can also fall into this category.

Another category is self-employed persons who report their income and expenses on their personal tax return.  There is a gross and a net business income reported, supported by a schedule breaking down the income and expenses by category.  The simplest approach is to use the net income reported on the taxes.  If the debt ratios work, there is no point in complicating it further.  Some lenders, within reason, allow  add-backs of some common expenses such as motor vehicle, use of home, capital cost allowance or alternately apply a gross up factor such as 15% to the net income to compensate for those type of expenses.

A subset of the self-employed is dividend income reported on the personal tax return, explained further in the proceeding category.

The last category belongs to those who do not report income via the above-mentioned traditional means. Examining income in this category is more case by case,  lenders use a common sense and reasonability approach. This could be someone who is incorporated.  Financial statements and corporate tax returns can be examined in this case.  Often, there are dividends or paystubs issued, which are then reported on the applicant’s personal tax return.  This may put the applicant back in the first two group noted above, making the approval more straightforward.  If the debt ratios work with those income numbers shown on the personal tax return, there may be more lender options available.

Another example of this category is the self-employed person who is earning more than their historical tax returns indicate in the self-employment section (often due to business growth year over year) or someone who is newly self-employed. In either case, using the number reported in the personal tax return is not sufficient to support the debt ratios, so further delving into documentation is required.  A number of documents can be reviewed to prove the income, including bank statements, invoices , contracts and proof of ownership of business.

If documentation is limited, or business income is cash oriented, there are lenders willing to accept ‘stated income’.  Stated income needs to be reasonable for the industry and location.  These programs were more plentiful in the past, but mortgage regulations have tightened up and put a high importance on fraud prevention and not over-extending consumer debt load.

Real estate investors need to take note: in general, many residential mortgage lenders are not as keen about rental income as the investors are.  Varying approaches to rental income calculation are used, some more forgiving than others (see blog here).  However, in many cases, even if positive cash flow results and debt ratios are within the policies, many lenders do not like to see a significant portion of total income needed to qualify for mortgage solely from rental property. They expect income from other ‘reliable’ sources, like employment.  Personally, I do not agree with this, in my view the investor is trying to create a sustainable financial future, more dependable than employment.   But one has to realize, successful real estate investors are a minority and lenders will err on the side of caution.  A  real estate investor earning a majority of their income from rental property consequently may find themselves in the last category, persons who do not report income via traditional means.

There are other less common sources of income that are not covered above, but in general, they still would fall into the three general category.

The first two categories typically fall into mostly ‘A’ lender space (see blog here).   Due to the complexity of document review, or added risk of limited documentation, the last category falls mostly into ‘B’ or alternate lender space or private lending, the latter applying to very difficult files, usually due to a combination of items, not simply issues with income.  Exceptions exist where an applicant from the last category may qualify for programs with A lenders if the mortgage is for owner-occupied property.  In general, there are more options, and more willingness for lenders to take risks with owner-occupied property than rental property.

With B lenders, fees and slightly higher rates may apply (note rates are now historically very low, so B lender rates are still below historical average A rates!). But there are advantages as well.  Because B lenders use a common sense approach, the application process may actually be more simple than an A lender (who may ask for your first born child, as we jokingly say in the mortgage industry).  Also, the terms and conditions can be more flexible.   And let’s not forget, the B lender may be able to say yes, while the A lender says no to you, and gets you closer to your goal.

Self-employment typically yields tax savings among many other benefits, but that may put one into B lender space. It is best to look at the big picture, and with the help of a mortgage broker, and assess whether trying to fit into A lender space  is worth it or even possible.  It may mean recording income differently and paying more taxes, consulting accountants and lawyers.  It can take a few years to fully implement.  A good first step is a mortgage planning session.